CEO explains how they are used in Venture Capital
Archimede Mulas London 20/07/2018
Although many people know Venture Capital (VC) for being the go-to place for startups looking to raise funding, few know how their structure works, and why they are so demanding.
A venture capital fund is set up as a Limited Partnership. In the UK these are to be registered under the Limited Partnerships Act of 1907. A partnership has to be made of two or more persons or companies. One or more will act as a general partner, and the others will be limited partners.
For a simple venture fund, the general partners will usually be a limited liability management company that acts as investment manager. General partners, also known as GPs, do not invest their capital in the fund, but are liable for any debt the business can’t pay. Setting up a limited liability company to act as a general partner limits the liability of the partnership.
GPs are investment professionals. Their role is to raise capital from limited partners for their fund, make investment decisions, and support their portfolio companies exit. GPs will be experts in their field, highly networked, or skilled growth experts. They owe a duty to the limited partners of substantial economic returns.
The investors in the fund are the limited partners, also known as LPs. Limited partners contribute money to the fund and are only liable up to the amount contributed to the fund. LPs don’t manage the VC and have no voting power dictating with whom the VC invests.
Limited partners will usually be high-net worth individuals, funds of funds (these are limited partnerships that invest in funds), corporate pension funds, foundations, sovereign wealth funds, family offices, and other institutions with risk appetite.
To join a Limited Partnership, LPs will usually pay a “2 and 20” fee to the general partners. The general partner will charge a 2% management fee of the LP’s assets, and a 20% success fee. A usual VC fund will operate between 7 and 10 years, after which the Limited Partners will want to see their return.
Because of this duty the GP owes to the LPs, VCs are in a situation where they sometimes need to force their portfolio companies to exit. To do this, VCs can ask for seemingly aggressive investment terms, in order to give them more control on how the startup is run and when it decides to accept a liquidity event.
Liquidity events are not the norm, with over 70% of the startups failing. This mortality rate also depends on the focus of the VC’s investment. General Partners will chose the focus of their portfolio, in accordance to their area of expertise and risk vs. return ratio. Usually the investments are focused on stage of the startup (maturity), geography, or sector.
Later stage companies are often considered too big to fail, and therefore less risky investments for large VC funds. This however is not necessarily the case. Yik Yak, a social media platform, who raised $73.5M and had a $400 Million valuation failed in 2017.
The success for a general partner comes from liquidity events of the fund’s portfolio companies. These happen during a share purchase, an acquisition (M&A) or an initial public offering (IPO). In the case of a non-successful startup, VCs can also sometimes see returns from insolvency proceeding.
A share purchase is a buyout from a new or current investor looking to own more shares in the company. An acquisition instead is when a larger company decides to merge the startup with their company and usually acquire all the shares. An IPO is when the company is listed on the public equity market, making the shares available to both institutional and retail investors.
GPs who can deliver these events to their LPs and to the founders allow startup ecosystems around the world to grow.